V PART The Core of Macroeconomic Theory

The level of GDP, the overall price level, and the level of employment—three chief concerns of macroeconomists—are influenced by events in three broadly defined “markets”: Goods-and-services market Financial (money) market Labor market

We build up the macroeconomy slowly.  FIGURE V.1 The Core of Macroeconomic Theory We build up the macroeconomy slowly. In Chapters 23 and 24, we examine the market for goods and services. In Chapters 25 and 26, we examine the money market. Then in Chapter 27, we bring the two markets together, in so doing explaining the links between aggregate output (Y) and the interest rate (r), and derive the aggregate demand curve. In Chapter 28, we introduce the aggregate supply curve and determine the price level (P). We then explain in Chapter 29 how the labor market fits into the macroeconomic picture.

23 Aggregate Expenditure and Equilibrium Output CHAPTER OUTLINE The Keynesian Theory of Consumption Other Determinants of Consumption Planned Investment (I) The Determination of Equilibrium Output (Income) The Saving/Investment Approach to Equilibrium Adjustment to Equilibrium The Multiplier The Multiplier Equation The Size of the Multiplier in the Real World Looking Ahead Appendix: Deriving the Multiplier Algebraically

aggregate output The total quantity of goods and services produced (or supplied) in an economy in a given period. aggregate income The total income received by all factors of production in a given period. In any given period, there is an exact equality between aggregate output (production) and aggregate income. You should be reminded of this fact whenever you encounter the combined term aggregate output (income) (Y). aggregate output (income) (Y) A combined term used to remind you of the exact equality between aggregate output and aggregate income.

The Keynesian Theory of Consumption consumption function The relationship between consumption and income.  FIGURE 23.1 A Consumption Function for a Household A consumption function for an individual household shows the level of consumption at each level of household income.

The Keynesian Theory of Consumption With a straight line consumption curve, we can use the following equation to describe the curve: C = a + bY  FIGURE 23.2 An Aggregate Consumption Function The aggregate consumption function shows the level of aggregate consumption at each level of aggregate income. The upward slope indicates that higher levels of income lead to higher levels of consumption spending.

The Keynesian Theory of Consumption marginal propensity to consume (MPC) That fraction of a change in income that is consumed, or spent. aggregate saving (S) The part of aggregate income that is not consumed. S ≡ Y – C

The Keynesian Theory of Consumption identity Something that is always true. marginal propensity to save (MPS) That fraction of a change in income that is saved. MPC + MPS ≡ 1 Because the MPC and the MPS are important concepts, it may help to review their definitions. The marginal propensity to consume (MPC) is the fraction of an increase in income that is consumed (or the fraction of a decrease in income that comes out of consumption). The marginal propensity to save (MPS) is the fraction of an increase in income that is saved (or the fraction of a decrease in income that comes out of saving).

Aggregate Consumption, C The Keynesian Theory of Consumption  FIGURE 23.3 The Aggregate Consumption Function Derived from the Equation C = 100 + .75Y In this simple consumption function, consumption is 100 at an income of zero. As income rises, so does consumption. For every 100 increase in income, consumption rises by 75. The slope of the line is .75. Aggregate Income, Y Aggregate Consumption, C 100 80 160 175 200 250 400 600 550 800 700 1,000 850

AGGREGATE CONSUMPTION The Keynesian Theory of Consumption  FIGURE 23.4 Deriving the Saving Function from the Consumption Function in Figure 23.3 Because S ≡ Y – C, it is easy to derive the saving function from the consumption function. A 45° line drawn from the origin can be used as a convenient tool to compare consumption and income graphically. At Y = 200, consumption is 250. The 45° line shows us that consumption is larger than income by 50. Thus, S ≡ Y – C = 50. At Y = 800, consumption is less than income by 100. Thus, S = 100 when Y = 800. Y  AGGREGATE INCOME C AGGREGATE CONSUMPTION = S AGGREGATE SAVING 100 -100 80 160 -80 175 -75 200 250 -50 400 600 550 50 800 700 1,000 850 150

The Keynesian Theory of Consumption Other Determinants of Consumption The assumption that consumption depends only on income is obviously a simplification. In practice, the decisions of households on how much to consume in a given period are also affected by their wealth, by the interest rate, and by their expectations of the future. Households with higher wealth are likely to spend more, other things being equal, than households with less wealth.

Planned Investment (I) planned investment (I) Those additions to capital stock and inventory that are planned by firms. actual investment The actual amount of investment that takes place; it includes items such as unplanned changes in inventories.  FIGURE 23.5 The Planned Investment Function For the time being, we will assume that planned investment is fixed. It does not change when income changes, so its graph is a horizontal line.

The Determination of Equilibrium Output (Income) equilibrium Occurs when there is no tendency for change. In the macroeconomic goods market, equilibrium occurs when planned aggregate expenditure is equal to aggregate output. planned aggregate expenditure (AE) The total amount the economy plans to spend in a given period. Equal to consumption plus planned investment: AE ≡ C + I. Y > C + I aggregate output > planned aggregate expenditure C + I > Y planned aggregate expenditure > aggregate output

The Determination of Equilibrium Output (Income) TABLE 23.1 Deriving the Planned Aggregate Expenditure Schedule and Finding Equilibrium. The Figures in Column 2 Are Based on the Equation C = 100 + .75Y. (1) (2) (3) (4) (5) (6) Aggregate Output (Income) (Y) Aggregate Consumption (C) Planned Investment (I) Planned Aggregate Expenditure (AE) C + I Unplanned Inventory Change Y - (C + I) Equilibrium? (Y = AE?) 100 175 25 200 - 100 No 250 275 - 75 400 425 - 25 500 475 Yes 600 550 575 + 25 800 700 725 + 75 1,000 850 875 + 125

The Determination of Equilibrium Output (Income)  FIGURE 23.6 Equilibrium Aggregate Output Equilibrium occurs when planned aggregate expenditure and aggregate output are equal. Planned aggregate expenditure is the sum of consumption spending and planned investment spending.

The Determination of Equilibrium Output (Income) The Saving/Investment Approach to Equilibrium Because aggregate income must be saved or spent, by definition, Y ≡ C + S, which is an identity. The equilibrium condition is Y = C + I, but this is not an identity because it does not hold when we are out of equilibrium. By substituting C + S for Y in the equilibrium condition, we can write: C + S = C + I Because we can subtract C from both sides of this equation, we are left with: S = I Thus, only when planned investment equals saving will there be equilibrium.

The Determination of Equilibrium Output (Income) The Saving/Investment Approach to Equilibrium  FIGURE 23.7 The S = I Approach to Equilibrium Aggregate output is equal to planned aggregate expenditure only when saving equals planned investment (S = I). Saving and planned investment are equal at Y = 500.

The Determination of Equilibrium Output (Income) Adjustment to Equilibrium The adjustment process will continue as long as output (income) is below planned aggregate expenditure. If firms react to unplanned inventory reductions by increasing output, an economy with planned spending greater than output will adjust to equilibrium, with Y higher than before. If planned spending is less than output, there will be unplanned increases in inventories. In this case, firms will respond by reducing output. As output falls, income falls, consumption falls, and so on, until equilibrium is restored, with Y lower than before.

The Multiplier multiplier The ratio of the change in the equilibrium level of output to a change in some exogenous variable. exogenous variable A variable that is assumed not to depend on the state of the economy—that is, it does not change when the economy changes.

The Multiplier At point A, the economy is in equilibrium at Y = 500.  FIGURE 23.8 The Multiplier as Seen in the Planned Aggregate Expenditure Diagram At point A, the economy is in equilibrium at Y = 500. When I increases by 25, planned aggregate expenditure is initially greater than aggregate output. As output rises in response, additional consumption is generated, pushing equilibrium output up by a multiple of the initial increase in I. The new equilibrium is found at point B, where Y = 600. Equilibrium output has increased by 100 (600 - 500), or four times the amount of the increase in planned investment.

The Multiplier The Multiplier Equation Recall that the marginal propensity to save (MPS) is the fraction of a change in income that is saved. It is defined as the change in S (∆S) over the change in income (∆Y): Because DS must be equal to DI for equilibrium to be restored, we can substitute DI for DS and solve: Therefore, It follows that , or

The Multiplier The Size of the Multiplier in the Real World In considering the size of the multiplier, it is important to realize that the multiplier we derived in this chapter is based on a very simplified picture of the economy. In reality, the size of the multiplier is about 2. That is, a sustained increase in exogenous spending of $10 billion into the U.S. economy can be expected to raise real GDP over time by about $20 billion.

Looking Ahead In this chapter, we took the first step toward understanding how the economy works. We assumed that consumption depends on income, that planned investment is fixed, and that there is equilibrium. We discussed how the economy might adjust back to equilibrium when it is out of equilibrium. We also discussed the effects on equilibrium output from a change in planned investment and derived the multiplier. In the next chapter, we retain these assumptions and add the government to the economy.

R E V I E W T E R M S A N D C O N C E P T S actual investment aggregate income aggregate output aggregate output (income) (Y) aggregate saving (S) consumption function equilibrium exogenous variable identity marginal propensity to consume (MPC) marginal propensity to save (MPS) multiplier planned aggregate expenditure (AE) planned investment (I) 1. S ≡ Y − C 2. 3. MPC + MPS ≡ 1 4. AE ≡ C + I 5. Equilibrium condition: Y = AE or Y = C + I 6. Saving/investment approach to equilibrium: S = I 7.